Dave Ramsey And The Power of Behavioral Finance

By Pinyo, on July 21, 2009

I didn’t always agree with Dave Ramsey because I think some of his recommendations aren’t mathematically efficient. But as I pass my two years mark as a personal finance blogger, I must admit that have a growing appreciation for his school of thought. After all, we are human beings and not robots — so, mathematically best does not work as well as we’d like it to.

Examples of Behavioral Finance at Work

There are several things that Dave Ramsey recommends which emphasize human psychology and behavior. For example:

Emergency Fund

In his Baby Steps to Financial Freedom, Dave Ramsey recommends starting a $1,000 emergency fund before you even try to tackle your debt. I thought this didn’t make sense, because I felt you should pay off debt as fast as you can. After all, you can always use your credit card for emergencies. However, this method actually reduces the chance that you will succumb to the old habit that got you into debt in the first place.

Moreover, with more and more credit card issuers tightening their lending policy. It’s probably a good idea not to depend on your credit card for emergencies. Even Suze Orman changed her recommendation on paying off credit card debt versus building an emergency fund as a result of this latest economic crisis (compare to her original recommendations you can find in her books).

Debt Snowball

Which debt first? This is an ongoing debate in the personal finance community. Dave Ramsey advocates smallest balance first so that you can taste success sooner and see how the Debt Snowball works. This might not be mathematically best because the smallest balance may not be your most expensive debt — i.e., your highest interest rate debt. However, his method is psychologically sound.

I am not here to argue for or against Dave Ramsey and behavioral finance. However, I think it’s a good idea for you to see the difference so that you can determine for yourself which school of thought is best for you.

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Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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5 Comments

Kelly
July 22, 2009, 11:36

Interesting points. I’d never had thought that tackling smaller credit card balances first, rather than the most expensive ones, would work. But I agree with you that it makes sense from a psychological point of view.

It’d be really interesting to see some evidence on which one of the two approaches works better.

Thanks for a thought-proviking post!
Joe Plemon
July 22, 2009, 16:04

“Behavioral finance” is an apt description of what Dave Ramsey advocates. The real proof, as they say, is in the pudding and Dave’s Baby Steps have helped millions change their behavior and thus their finances.

Thanks for the insightful post.
AJ
July 22, 2009, 16:38

Dave Ramsey is great!
Rob Bennett
July 24, 2009, 7:28

Great blog entry, Pinyo.

Behavioral finance is of huge importance. So is looking at the numbers. Both add something important.

Is it more important to fall in love or to find a way to pay the bills? Romance without finance is a nuisance. But having lots of money and nothing you love to spend it on is a sad business.

There is today too much of a focus on the numbers. Ramsey has helped address that imbalance, in my assessment.

Rob
Peter
July 24, 2009, 12:42

This post highlights what I think the idea that psychology and behavior does have to come into play when you’re talking about personal finance. People that are purely analytical probably don’t need Ramsey’s methods in the first place because they’re knowledgeable, motivated and probably haven’t gotten themselves into trouble in the first place. For other regular folks who are struggling their way out of debt, Dave Ramsey gives a good solid plan that takes into account multiple factors to help people get out of debt and build wealth effectively – even if it isn’t always the best mathematical way.

As for whether you use Ramsey’s methods or not – as Ramsey says- you can’t go wrong getting out of debt! Whatever you use, and that works, is just fine!

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